Credit Risk

Key Highlights

• Credit Risk refers to the potential loss an investor faces if a borrower such as a company, financial institution, or government fails to meet its debt obligations, either by delaying payments or defaulting entirely.

• Types of credit risk involves default, downgrade and credit spread risk.

What is Credit Risk?

Credit Risk refers to the potential loss an investor faces if a borrower such as a company, financial institution, or government fails to meet its debt obligations, either by delaying payments or defaulting entirely. It is one of the most critical factors assessed in fixed-income investing, lending decisions, and portfolio construction.

Key Drivers of Credit Risk

• Financial Strength of the Issuer: An issuer’s ability to consistently generate revenues, maintain healthy profit margins, and produce stable cash flows is central to meeting debt obligations. Strong financials reduce the likelihood of delayed payments or default.

• Leverage & Capital Structure: The level of existing debt on a company’s balance sheet directly impacts its repayment capacity. Highly leveraged companies carry greater default risk, as a larger portion of their earnings must be allocated to interest and principal payments.

• Sector & Macroeconomic Conditions: Credit risk is also shaped by broader economic and industry-specific factors. Businesses operating in cyclical or highly regulated sectors may face higher uncertainty. Macroeconomic elements such as inflation, GDP growth, and interest-rate movements further influence an issuer’s ability to repay.

• Liquidity Position: A company’s access to cash and liquid assets determines how easily it can meet short-term financial commitments. Strong liquidity serves as a buffer during periods of stress, lowering the probability of payment delays or restructuring.

Types of Credit Risk

1. Default Risk: The risk that the issuer cannot repay interest or principal.

2. Downgrade Risk: The possibility that a credit rating agency lowers the issuer’s rating, affecting the bond’s price and yield.

3. Credit Spread Risk: The risk of widening spreads between corporate bonds and government securities due to perceived deterioration in credit quality.

Why Credit Risk Matters for Investors

Understanding credit risk helps Indian investors:

• Make informed decisions about corporate bonds, NCDs, and market-linked debentures

• Evaluate the trade-off between yield and safety

• Diversify fixed-income allocations to reduce default exposure

For long-term wealth creation, prudent credit risk evaluation supports stable, resilient portfolios, especially in volatile market cycles.